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Inflation during economic shock

What exactly is inflation? Essentially, inflation (or deflation) is a seller of goods or services attempting to maximize profit without losing market share. Basically, the seller is manipulating the price based on customer reaction using a battery of marketing gimmicks and tactics to reach that objective. Inflation is therefore a measure of competitive pricing, although not a very reliable one for reasons outlined below.

A questionable application of inflation is its connection to indexed bonds. It is questionable since the inflation measure is based on prices a backward in time whereas the application occurs one month forward. There are also statistical adjustments applied that skew the result even further (e.g. adjusting for spring and fall clearance sales prices which are part of the yearly sales cycle). If merchants raise prices in June, indexed mortgage loans will rise in July or August despite the fact that prices may actually have gone down. The other issue is that of the actual basket used for measuring inflation.

When the Icelandic economy collapsed October 2008, the exchange rate collapsed with it which caused a massive price increase on all imports. Inflation rose rapidly and put around a third of Icelandic households in an impossible debt situation. When the items used to measure inflation were examined, we found:

  • 4-wheel bikes
  • Snowmobiles
  • Luxury cars
  • Home entertainment systems

and a wide assortment of other high-ticket items in demand during Iceland’s economic peak. Sales of these items dropped to almost 0 immediately after the collapse, yet households incurred a debt increase nonetheless. Inflation measurements in the months that followed were completely inaccurate and sent several households into bankruptcy for no reason. We estimated that inflation was overrated by nearly HALF in November and December 2008 by looking at retail and wholesale turnover figures. A closer view at turnover v. inflation reveals the peculiar behavior between the two series.

Synchronizing the series required some manipulation as inflation is reported monthly but turnover every two months. In order to fill the turnover gaps, the series are turnover into a 2-month moving average. Change from same month prior year is then applied. The series begin December 2005 and end December 2010.

The first chart shows car sales. Observe the massive drop in turnover while inflation continues to move upward. The green area is the difference between inflation level and turnover. The second chart compares fuel, the third car parts and the fourth household goods. In order to maintain sales, retailers will lower unit prices through discounts sales and other bargain deals. Obviously this becomes difficult if the base price is directly linked to foreign currencies as is the case for fuel. Fuel provides a good overview how this works.

Statistics Iceland provides quarterly measurement of actual price levels; the Central Bank of Iceland monthly overview over debt categorized based on credit type and lender category. In order to make price levels comparative, the data had to be manipulated (download the source spreadsheet).

The thick red line shows fuel retailer turnover; the thick purple line the rise in company indexed loans. Notice how turnover drops as the market reacts to price increases, yet the debt burden on companies increases. The reason is that the weight of fuel is reviewed at fixed intervals during the year instead of following changes in consumer behavior. The increased debt burden is therefore not driven by actual market conditions but is of artificial nature. Indexed bonds must follow actual consumer trends in order to react to market changes. If the market’s reaction to sudden price spikes is ignored, the efforts of businesses and households to stay afloat will be futile.

In order to prevent this type of situation from happening again, we need an alternative inflation indicator that operates in near real-time. By connecting the POS systems of major retailers to a central EU database (preferably Eurostat) which tracks price/volume changes on all items sold (tracked by item code), it will serve as a safety measure against this kind of occurrence. In addition, it will increase price competitiveness and make it easier for new businesses to price their goods and services. This alternative inflation measure will reveal price levels as they are right now; not a week or a month ago. It will also show reactions to economic situations (natural disasters, strikes and so on) that the current method ignores. Most of all, it will link directly to the exchange rate and thereby open the gates to a completely new dimension as far as economic management, investment and banking is concerned.


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